Crypto Credit Market Structure 101

The Crypto Credit Landscape
One area in crypto that consistently feels misunderstood by both insiders and new market observers alike is crypto credit.

This report provides an introduction to the state of crypto credit markets, including a look at unique market structure characteristics that drive the supply and demand of crypto credit; and concludes with comments from various industry participants on the opportunities that remain within the broader crypto credit ecosystem.

The crypto market is still evolving in its quest to figure out how to rationally price and sell counterparty risk, but to be fair, the pricing and selling of risk is what ultimately helps drive the net benefit of price discovery, deeper liquidity, and ultimately maturation of a market. All good things, to be sure.

To date, crypto credit extension has predominately been provided via secured lending; requiring borrowers to post cryptoassets as collateral — typically significantly overcollateralized to protect against higher levels of asset volatility — in exchange for either crypto or dollar-denominated stablecoins. Loans can be originated centrally with a traditional credit desk or prime broker (Centralized Finance - CeFi) or through a decentralized non-custodial lending protocol (Decentralized Finance - DeFi).

Centralized Finance (CeFi): Retail and institutional traders and funds that want to use leverage to either express long/short directional views or for risk-neutral trading strategies can either use product leverage (implicit) offered by centralized exchanges through levered derivative products such as futures, options, perpetual, or spot margin; or can receive portfolio leverage (explicit) from traditional credit desks and prime brokers that provide credit.

Decentralized Finance (DeFi): DeFi services are often conceptually quite similar to traditional financial services, and the most successful ones to date have been focused around core financial primitives like asset exchange and lending.

Of the five DeFi protocols with more than a billion dollars of value deposit within smart contracts, three are lending protocols. Compound and Aave are straightforward money markets — there are borrowers and lenders, and interest rates are determined by a function that takes in risk parameters where factors like volatility are considered. Users can place assets into a pool and borrow other assets against their collateral. MakerDAO adds a wrinkle to the mix in that the borrowed asset is a stablecoin that targets the price of 1 USD.

Similar to the product and portfolio leverage being extended from CeFi, a core component of credit that DeFi lacks is the ability to extend unsecured credit. Everything at the system level has to be overcollateralized today as counterparties are not judged by their creditworthiness due to a lack of a viable decentralized identity system. More recently, new protocols such as TrueFi, Maple.Finance and C.R.E.A.M (Iron Bank) offer examples of protocols in the early stages of experimenting with unsecured credit-based models that aim to delegate or whitelist borrowers and other protocols for unsecured borrowing. But it remains early on that front.

One of the key differences between the demand for non-custodial leverage within DeFi vs. traditional leverage in CeFi is the intended use of the borrowed funds. Users that supply collateral into non-custodial with the intention of using within DeFi ecosystem have a number of ways to use the proceeds, including:

To trade other assets via decentralized exchanges (DEX)
To 'stake' and receive transaction fees or other token incentives. E.g. borrow Token X to farm and receive Token Y
To lever long/short other assets via derivative protocols
Rarely, to take out of the DeFi ecosystem to use elsewhere

We've summarized the two crypto ecosystems in the visualization below (click to enlarge).

Sizing the market
According to estimates from Arcane Research, by the end of February 2021, the amount of bitcoin used as collateral across derivatives products, collateralized lending, and within DeFi (wrapped bitcoin) totaled nearly $30 billion dollars or ~625,000 bitcoins (the price of 1 BTC at the end of February was ~$45K and total bitcoin open interest ~$15 billion vs. today's price of ~$55K-$60K and ~$20 billion in total open interest). Arcane Research estimates that number counts for just ~15 basis points of the total size of the secured collateral market across asset classes (largely government bonds and U.S. treasuries used as collateral).

While the market for crypto lending may still be small relative to other credit markets, the rapid growth in value of the entire crypto asset class (>$2 trillion), the creation of a new financial system (DeFi), and the ability to provide working capital for companies in the broader ecosystem all speak to the opportunity for crypto credit to maintain its growth in the coming years. Notwithstanding, the backbone to which credit plays within market making itself, for an asset class that saw crypto exchanges clear nearly half the volumes on NYSE Group's stock markets in February (~$1.2 trillion).

The core demand for crypto credit and product offerings can be segmented as follows:

Non-trading (leverage) use cases for crypto secured loans: Personal or business loans originated by custodial lenders against crypto, with USD wired directly to bank accounts. Loans can be used for additional liquidity, to use for working capital purposes, and offer tax benefits on unrealized capital gains (allow holders to not sell holdings).
Crypto-secured collateralized lending to serve the demand for portfolio leverage (explicit): Origination volumes are largely used to fund trading strategies, as the loans can be used to express either direction long or short position or run various risk-neutral trading strategies. Genesis is one of the largest (if not the largest) providers of portfolio leverage (explicit leverage). In 2020 the company originated more than $19 billion worth of loans ($7.6B in 4Q'20, up +7x since 4Q'19). In the first quarter of 2021, originations actually surpassed the entire cumulative originations to date at over $20 billion in the quarter — a testament to the pace of growth in the market for crypto collateralized credit. Elsewhere, BlockFi, one of the world's largest crypto-native neobanks, originated ~$18 billion in loans across its institutional services business in 2020 (per Arcane Research).
Margin and other product leverage on exchanges: The ability to use leverage (implicit) via derivative products or direct margin from exchange themselves. Traders post collateral (crypto or stablecoins) with the exchange acting as the clearinghouse and the ability to auto-liquidate positions that dip below specified collateralization ratios. While some may point to the ability to receive up to 100x leverage via derivative products at various exchanges as evidence of higher levels of leverage in the system, the current open interest of bitcoin futures (~$20B) is only ~2% of the total market value of all bitcoin (and has held relatively steady through time). For context, this is slightly higher than gold futures open interest to total gold value (~1%), assuming ~$100B in total open interest and an above-ground total gold value estimate that can range anywhere from $8-$10T+, according to Goldhub.

Source: The Block Research, Goldhub

Decentralized Lending Protocols (non-custodial): Non-custodial lending protocols offer similar collateralized credit as custodians, only in a decentralized way. While risks of smart contract bugs and exploitations are present within this new system, the lack of needing to trust a centralized credit provider to properly custody and manage counterparty risks can offer a favorable tradeoff. Other advantages of non-custodial lending include: 1) global 24/7 access to credit with near-instant settlement; 2) greater real-time transparency into outstanding loan books and risks within the system; 3) assurances that the set rules of the system are being maintained; and 4) a new financial infrastructure that allows for applications to be interoperable with one another out of the box.

Alternatively, lending protocols may not be suitable for credit needs, like institutional borrowers that require KYC assurances of who they are lending and borrowing from. Some systems built on public blockchains by nature may also weaken borrowing privacy (also particularly an issue for institutional borrowers). Leading non-custodial lending and money market protocols on Ethereum (Aave, Compound, and Maker) as of May 2021 combined for more than $17 billion in outstanding debt, with more than $40 billion in crypto collateral stored within smart contracts.
Token-based platforms: A catch-all bucket for any lending and depository platform that pays out interest in its own native token. Large players here include Nexo and Celsius, which according to Arcane Research, have originated more than $13 billion in loans as of Feb 2021.

Unique market structure constraints still persist within crypto that inhibits capital efficiency
Bitcoin, and other cryptocurrencies like Ether, offer unique collateral characteristics that make them favorable to lend against, assuming the loan is over-collateralized in order to mitigate underlying price volatility. Some of these characteristics include: 1) asset is received instantly (little to zero clearing friction); 2) efficient storage and can be sent anywhere in the world; 3) can be liquidated 24/7; and 4) is constantly marked-to-market.

However, unlike traditional markets which use central clearing firms and primes to allow for standardized cross-margining between exchanges, product margin extended by crypto exchanges require all positions to be pre-funded at each venue with margin requirements that vary from exchange to exchange (there is no equivalent to a standard minimum liquidity requirements that a Reg T in traditional markets specifies). This leads to significantly higher collateral requirements needed for traders and market makers that want to trade across multiple crypto exchanges to find the best execution, and/or effectively execute price arbitrages.

Source: CoinShares Research

Why are yields so high in crypto and can they sustain?
Yields are a function of the desire for leverage (demand side) and attractive yield opportunities (supply-side).

The demand for attractive yield opportunities drives the supply side of credit
There are a number of yield opportunities in crypto with return rates that are significantly higher than traditional markets. Structural factors such as a lack of cash borrow provided by larger and more traditional balance lenders have helped to contribute to more persistent attractive trading strategies on the demand for credit — at the cost of higher cash borrowing costs and thus reduced levels of portfolio leverage for the broader ecosystem.

Cash shortage in the system paired with a high leverage appetite allows depository institutions the ability to pay higher interest rates on stablecoins. A massive appetite for leverage during the bull market, paired with a limited number of more traditional large balance sheet lenders, has led to a shortage of dollar-denominated debt. Even with stablecoin supply tripling since the beginning of the year from $25 billion to +$75 billion today, interest rates on dollar-backed stablecoins can run as high as 10%. Depository institutions can afford to pay up for these deposits as a funding source for loans at higher rates because, in many cases, these institutions can actually lend out stablecoins at even higher borrow rates due to attractive trading opportunities within the demand for leverage. Considering the crypto lending market is still emergent, there aren't a lot of traditional banking institutions funding loans into the space; but that may soon be coming to a close.

Last month, crypto’s premier exchange payment network and banking partner Silvergate continued to project confidence in its ability to grow cash-denominated loans on bitcoin collateral through its SEN network. Elsewhere, Signature Bank, a top 50 U.S. bank by deposits, signaled its intention to “start doing some lending in the crypto digital world.” In the U.S., OCC interpretive letters in 2020 stated banks would be allowed to custody, service crypto markets, and hold reserve assets behind stablecoins. Since then banks such as BNY Mellon, and U.S. Bank have announced this year the intention to offer crypto custody services — a prerequisite to being able to offer credit to the crypto.

All else equal, the addition of larger balance sheet lenders should help to reduce the cost to borrow cash and increase portfolio leverage within the asset class.

Funding rate arbitrage. A perpetual swap is a financial contract where a buyer is buying synthetic exposure to a financial asset and a seller is shorting exposure to that same asset. Perpetual refers to the synthetic asset having no expiration date — unlike a futures contract that settles at some date. Exposure is maintained perpetually. The price of a futures contract converges to the spot price because, at expiration, the payout is tied to the spot price. Perpetual swaps don’t have the expiry date to force the synthetic price to track the spot/index price, and thus there needs to be another mechanism to incentivize the two to stay in sync. This is done primarily via funding payments between long and short positions. When the price of the perpetual swap exceeds the index price, longs pay shorts a periodical fee to incentivize short sellers to enter the market and/or decrease the incentive to stay long (and vice-versa). The funding rate creates a profit opportunity. Most of the time, despite market conditions, the funding rate will be positive over a longer time-horizon and longs will pay shorts. Especially during a bull market, funding rates can be extremely high. In 2021, the average APY on BitMEX’s XBTUSD contract is 0.04% (54.9% annualized).

Source: Binance

A function of an inefficient market and a reward that needs to be compensated for higher levels of risk. Finally, many of the yield-generating opportunities are not well-publicized and tied to products that benefit from crypto being a nascent market. For example, perpetual swaps have been a retail-focused product due to their simplicity, and some of the best yields from token distributions come at the expense of some subset of token holders. Among DeFi’s liquidity mining programs, profit strategies like within protocols like Curve are profitable simply because there are many variables to maximize yields (at the expense of other holders). CRV distribution between 20+ pools is determined by weekly voting, and locking up CRV for 4 years provides a 2.5x boost (progressively increasing, based on time-locked) — being in the right pool and maximizing the boost is an art form. Only 49.6% of CRV is locked for boosts, meaning more than half the supply is not maximizing its returns.

Demand to borrow crypto for leverage
We covered how non-custodial funds are typically used within DeFi in the landscape section above, so we'll point out the most popular (and often crowded) uses for leverage within the centralized finance crypto ecosystem.

The demand for credit of crypto and cash is exposed to a number of cyclical trading strategies that shift depending on the broader crypto market sentiment and performance: whether that's futures curve positioning, Grayscale GBTC trade, basis trade/cash and carry trade, demand to arb DeFi, or demand to directionally express levered long/short.

The two most crowded trades historically — which tend to orchestrate the supply and flow of assets around the ecosystem — are the basis/cash carry trade, and the GBTC premium trade:

Basis/cash carry trade. The bitcoin ‘basis trade’ has largely become an open secret. The trade, by which traders use a combination of long and short positions to harvest the spread between a future and the underlying spot price, averaged nearly 22% annualized return across FTX bitcoin basis in 1Q’21. Considering the basis trade uses one leg of the trade to buy spot and the other to short futures, this injects bitcoin supply into the market and reduces the borrow rates on BTC, all else equal. According to Genesis, the firm has seen "seen a material reduction in BTC borrow rates over the quarter as a result of the structural forward curve shift into contango... as traders can earn extra yield by lending out the spot purchase leg of the trade, or post the [BTC] as collateral to get a cash loan to recycle back into the basis capture."

Per the report, the persistence of this basis trade continues to speak to the demand for larger and more traditional banks to step into this market and provide cash-denominated loans on bitcoin collateral. Others will blame structural product issues for the persistently outsized basis. At venues like FTX, borrowers who use non-USD collateral for a basis trade face liquidation of their collateral for dollars if one leg of the trade has losses that surpass more than $30,000 (h/t Corey Hoffstein) — even if netting the other leg of the trade still results in a positive total position. Sure, there are likely more active ways to get around this (and other venues like Binance have coin-margin-specific products which avoid this problem entirely), but many in crypto aren’t compelled to jump through extra hoops to realize only a 20% annualized return. In other words: bull market problems.

Source: Genesis Q1'21 Market Observation

GBTC trade (and current unwind). Grayscale Investments, the world's largest digital currency asset manager, operates a number of investment trust products that provide exposure to various crypto assets. The firm's most popular product, the Bitcoin Investment Trust (GBTC), currently sits above $35 billion (around 655,000 bitcoins) in assets under management (AUM), up more than 15 times since last year. The GBTC product is big business: The Block Research estimates that Grayscale made north of $60 million off this AUM alone in April.

Grayscale's Bitcoin Trust issues common units of fractional shares, GBTC, which represent ownership in the trust to accredited and authorized investors in exchange for bitcoins. Then there is a six-month lockup period. Unlike an exchange-traded fund (ETF) where the fund provider owns all the assets in the fund and then sells shares to investors (meaning investors don’t physically own the assets in the fund) the GBTC product allows investors to lock up bitcoin that they own in the trust and redeem for shares of GBTC. Shares are issued in blocks of 100 per basket, and then trade freely on a number of venues. Since shares can be purchased at brokerages such as Charles Schwab, E*Trade, Fidelity, Vanguard and Interactive Brokers, GBTC offers retail traders one of the only ways to get bitcoin exposure within their 401K and IRA accounts.

Historically, the total market value of outstanding GBTC shares has traded at a premium to the total value of bitcoins held in the trust — ranging from 10-25% in 2020. This premium has provided accredited and authorized investors (hedge funds, market makers, crypto lending desks, etc.) that can buy into the trust issuance with an attractive trade opportunity that can be realized with a few options. The simplest way is to just hold the locked shares through the six-month lockup window and then sell unlocked shares at the market value at a premium. But a more popular risk-neutral strategy is through the use of credit and other structured products to short GBTC and capture the spread. As long as the premium holds six months past the lockup, investors can profit off this spread assuming the premium is larger than the cost to borrow if the trade uses credit products to short GBTC.

For the past three months, however, the total value of GBTC shares has actually been trading at a discount to the total value of bitcoins in the trust. Some have speculated that this is due to larger investor redemptions that have surpassed the 6-month lock-up and a flood of new bitcoin trust and exchange-traded products currently hitting the market. Regardless, Genesis also called out that the presence of the now GBTC discount has evaporated the demand to borrow BTC to arbitrage the premium, and helped to contribute to a reduction in bitcoin borrow rates. Between the presence of a bitcoin 'basis trade' (causing an increase in bitcoin supply) and the unwind of the 'GBTC premium' it's no surprise that lenders such as BlockFi have recently had to reduce bitcoin interest rates. The consensus view if both of these dynamics persist would be that other depository institutions trim bitcoin interest rates as well.

A lot of these demand and supply dynamics can vary widely depending on the current market environment and regime. For more on how these dynamics have changed over the past couple of years, it's worth revisiting previous Genesis Lending and Market Observation reports — particularly in quarters where there was a drastic shift in broader market sentiment and performance (1Q'21, 4Q'20, 1Q'20, etc.)

Source: Genesis, The Block Research

Perspectives from the industry: the opportunities on the horizon

The Block Research asked industry participants to share their views on what opportunities still exist for the crypto credit ecosystem at large and what tech solutions could help to improve capital efficiency for the asset class.

The full responses are aggregated in quote cards below, but a few consistent threads emerged from these conversations:

Opportunity for third-party tech providers to offer solutions that improve capital efficiency and reduce credit risks. With crypto now a trillion-dollar asset class with derivatives volumes exhibiting parabolic growth, a critical piece missing in the crypto market infrastructure is an efficient and trusted clearing mechanism that increases capital efficiency and reduces counterparty credit risk. Includes solutions such as improving better connectivity between ecosystem participants, privacy-preserving risk monitoring tools, cross-margining across both single and multiple exchange accounts, and faster exchange funding routes as notable missing pieces in the ecosystem today.
Opportunity to connect CeFi to DeFi to use as both a lower cost funding source and a way to deploy capital to earn higher yields. The current market dynamics for (centralized) crypto lending desks are already being influenced by DeFi, despite the risks and lack of maturity. Today, there are more “crypto-native” players who are willing to take on the risk and are (at least seemingly) capable of doing due diligence on the risks. Based on the opinion of what the risks are, this can be considered either arbitrage or just pricing risk differently. Lending desks can evaluate actors they are willing to extend credit to, based on their track level and level of due diligence on the potential risks. To date, there are some notable examples of custodians (or technology providers to custodians and institutions) integrating DeFi into their services. For example:

- Coinbase Custody offers a direct integration to Compound’s and MakerDAO’s governance process. This means their customers are able to participate in governance decisions or delegate their votes to active community stakeholders without our tokens leaving supported custody infrastructure.
- OKEx has enabled users to earn interest on Compound or via MakerDAO’s DSR, as well as provide liquidity on Uniswap.
- Curv (acquired by PayPal) recently announced the launch of its DeFi solution, which enables institutions to interact with any DeFi protocols or smart contracts — replacing the retail browser wallet or custom integrations. Curv’s new partnership with MetaMask makes signing transactions possible from the browser, which combines the existing user experience with their security infrastructure.
- Similarly, Fireblocks expanded their coverage from Compound support to many major DeFi protocols — derivatives exchange dYdX and providing liquidity on Uniswap.
- Trustology’s Metamask integration allows approving transactions from their vaults when interacting with DeFi protocols.

For institutional investors to better participate in DeFi, they require tools that are integrated directly with their custody solutions. In addition, improved tools for understanding and managing the multitude of risks associated with crypto protocols will also need to evolve.

Getting credit from multiple sources improves efficiency and reduces moral hazard. In traditional markets, central clearinghouses and prime brokers serve as trusted warehouses of credit, facilitating trading by representing someone’s spending power across multiple venues and counterparties. One unique secondary effect of digital asset infrastructure fragmentation is an underlying market structure that is more entangled than traditional markets, one that sees crypto exchanges and OTC desks as some of the main companies looking to extend credit; and in some cases even go as far as to build prime-like offerings. That stands out when considering Nasdaq, NYSE, and market makers such as Virtu don't offer full prime services in traditional markets. For certain large trading firms and liquidity providers, it's important to be able to get credit from a variety of sources (lenders, exchanges, miners, etc), as there are potential moral hazard implications of trusting an intermediary or lender with full visibility and control of your positions, if that intermediary has their own trading desk.

While the ecosystem has developed multiple sources of credit providers that include prime brokers, traditional lending, and portfolio margin within an exchange, these solutions tend to be either: 1) efficiencies restricted to one exchange; 2) require using a central provider’s accounts; or 3) are solutions that don’t yet support cross-exchange efficiencies for derivatives.

The net effect of cross-exchange capital efficiency is greater liquidity on exchanges, better pricing and increased volumes.

Resources

Crypto Credit Market Breakdown - Jump Capital

Banking on Bitcoin - Arcane Research

BlockFi Company Intelligence: Building a neobank for crypto - The Block Research

Crypto Credit Report - Credmark

Understanding Crypto Credit Markets - CoinShares Research

Genesis Market Updates - Genesis

The Evolution of Crypto Lending - The Block Webinar

Challenges for institutional DeFi adoption - Honkasalo, The Block Research. 2020

A look at price risk-free yield strategies - Honkasalo, The Block Research. 2021

© 2021 The Block Crypto, Inc. All Rights Reserved. This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.

Ryan Todd

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